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Ch 10 Notes

Introductory Financial Accounting (University of Manitoba)

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ACC 1110 Chapter 10 1

J. Pai Standard Costs and Overhead Analysis
Standard Costs – Management by Exception

A standard is a benchmark or norm for measuring performance, so a standard cost is like a

budget of a unit. For examples, quantity and cost standards are set for each major input such as
direct materials and labour time.

Quantity standards specify how much of an input (minimum requirement, allowance of

spoilage & allowance of defects) should be used to make a unit or product or provide a unit of
service. Cost or price standards specify the allowable (expected) monetary spending for each
unit of the input; for examples, invoice price, freight-in charge & holding costs.

Actual quantities and actual costs of inputs are compared to the standards to identify (1) what
cost components have variances – favourable or unfavourable and (2) determine action plans to
minimize unfavourable variances. This process is called management by exception.

Setting Standard Costs: Ideal versus Practical Standards

Ideal standards required peak efficiency at all time, i.e., allowing no machine breakdowns or
other work interruptions. Practical standards allow for normal machine downtime and other
work interruptions – expected to be attained through reasonable and efficient efforts by the
average employee. Standards will become benchmarks for performance evaluation; therefore,
the tight yet reasonable practical standards are typically used.

Standard Cost Record / Card -- Variable Production Cost of Alpha

Standard Standard
Inputs Quantity Price or Rate Standard Cost
Direct materials 5.0 kilograms $2.00 $10.00
Direct labour 3 hours $22.00 66.00
Variable manufacturing overhead 1.5 hours $8.00 12.00
Total standard variable cost per unit $88.00

Are Standards the Same as Budgets?

Think of a standard as the budget of a unit and the budget as a total amount of many standard
units. Take product Alpha as an example, the standard cost of the product is $88 – direct material
standard being $10, direct labour standard being $66, and variable manufacturing overhead
standard being $12.

When the company plans to make 10 units of Alpha, the production budget is $880 ($88 x 10).
To further break the production budget down, the direct materials budget is $100, direct labour
budget $660, and variable manufacturing overhead $120.

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J. Pai Standard Costs and Overhead Analysis
Variance Analysis

Variances are the differences between standard prices and quantities and actual prices and
quantities.

Static budget is a standard derived from standard unit cost at planned quantity of output.
Static budget variance is calculated to illustrate the monetary impact when actual unit cost and
actual production volume (or sales volume) are different from the original plan. This type of
variance is not derived based on actual output (production or sales volume) within the control
of the management, so it is not adequate for performance evaluation.

Flexible budget is a standard derived from standard unit cost at actual quantity of output.
Flexible budget variance is calculated by locking in at the actual output of finished product
produced (or sold for sales variance) while comparing actual unit product cost to standard unit
product cost, i.e. elements within management’s responsibility, thus, it is considered a suitable
variance for performance evaluation. Flexible budget variance can be further extended to 3 sets
of price and quantity variances as indicated in the chart below.

Here is the reconciliation of Variance Analysis:

Static Budget Variance

= Flexible budget variance + Volume budget variance
= (Price variances + Quantity variances) + Volume budget variance
= [(DM price var. + DL rate var. + VOH spending var.)
+ (DM qty var. + DL efficiency var. + VOH efficiency var.)] + Volume budget variance

A comprehensive chart of variance analysis is made available in the following page.

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ACC 1110 Chapter 10 3

J. Pai Standard Costs and Overhead Analysis

ACC 1110 -- Variance Analysis Overview

Static Budget Variance

(= Actual Cost of FG @ Actual Output Qty - Std. Cost of FG @ Planned Output Qty)
(=Flexible Budget + Activity Variance)
Actual Cost Flexible Budget Master Budget
Actual Cost of FG at Actual Std. Cost Allowed at Actual Std. Cost of FG at Planned
Output Quantity Output Quantity Output Quantity
Flexible Budget Variance
(= Total Price Variance + Total Quantity Variance)
(=DM P. Var. + DM Qty Var. + DL Rate Var. + DL Eff. Var. + VOH Spd'g Var. + VOH Eff. Var.)
(Volume Budget Variance)
Price Variance Quantity Variance Activity Variance
DM Price Variance DM Quantity Variance
DL Rate Variance DL Efficiency Variance
VOH Spending Variance VOH Efficiency Variance
Actual Cost Add-Ins for P/Q Var. Flexible Budget Master Budget
Planned Units of FG in
Actual Units of FG Made Actual Units of FG Made Actual Units of FG Made
Production
x x x x
Actual Input Quantity per Actual Input Quantity per Std. Input Quantity per Unit of Std. Input Quantity per
Unit of FG Unit of FG FG Unit of FG
x x x x
Actual Input Cost per Unit of Std. Input Unit Cost per Unit Std. Input Cost per Unit of
Input of Input Std. Input Cost per Unit of Input Input

DM Price Variance is calculated based on DM Quantity Purchased.

DM Quantity Variance is calculated based on DM Quantity Used in Production.

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J. Pai Standard Costs and Overhead Analysis
EXERCISE 10–3 Direct Labour Variances [LO3]

SkyInc provides in-flight meals for a number of major airlines. One of the company’s products
is stuffed cannelloni with roasted pepper sauce, fresh baby corn, and spring salad. During the
most recent week, the company prepared 6,000 of these meals, using 1,150 direct labour-hours.
The company paid these direct labour workers a total of $11,500 for this work, or $10 per hour.
According to the standard cost card for this meal, it should require 0.20 direct labour-
hours at a cost of $9.50 per hour.
Note: paying $10/hr, standard is 9.50/hrdisadvantage of $0.50 (unfavourable variance)
Required:
1. What direct labour cost should have been incurred to prepare 6,000 meals? How much
does this differ from the actual direct labour cost?
6000 x 0.2 DLH’s x $9.50 = $11,400
Output units x DLH’s per unit x DLC per hour = Actual Std. DLC (DLC Flex.
Budget)
This is $100 less than the actual cost incurredthey spent $100 too much
(unfavourable variance) (because actual cost > allowable cost)
2. Break down the difference computed in (1) above into a labour rate variance and a labour
efficiency variance.

Actual Cost: Actual Hours of input at the Actual Rate: (AH x AR) = $11,500
Add-in for P/Q Var: Actual Hours of input at the Standard Rate (AH x SR) = $10,925
Flexible Budget: Std. Hours allowed for output at standard rate (SH x SR) = $11,400

Rate Variance (between Actual and Add-in for PQ variance)= $575 (unfavourable)
Efficiency Variance (between flexible budget and add in for P/Q) = $475 (favourable)
Total Flexible Budget DL Variance = $100 (unfavourable)

SHORTCUT: Alternatively, Labour rate variance = AH(AR-SR) = 1150 (10 – 9.50) = $575
(U) Since Actual rate > standard rate, unfavourable.

REASON: A change in labour mix resulted in more wages because more skilled labour at
higher rates was used.

LABOUR EFFICIENCY VARIANCE = SR (AH-SH) = 9.50 (1150-1200) = $475 (F) since 1150
hours used is less than 1200 hours allotted.

REASON: A change in labour mix—with more skilled labour were used, so took less time to
finish.

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ACC 1110 Chapter 10 5

J. Pai Standard Costs and Overhead Analysis
EXERCISE 10–9 Material and Labour Variances [LO2, LO3]

The direct materials and direct labour standards for one bottle of Clean-All spray cleaner are
given below:
Standard Quantity Standard Price Standard
or Hours or Rate Cost
Direct materials. . . . . . . . . . . 6.0 milliliters $0.25 per milliliter $1.50
Direct labour. . . . . . . . . . . . . . 0.2 hours $12.00 per hour $2.40

During the most recent month, the following activity was recorded:
a. 20,000 milliliters of material was purchased at a cost of $0.20 per milliliter.
b. All of the material was used to produce 3,000 bottles of Clean-All.
c. 625 hours of direct labour time was recorded at a total labour cost of $7,500.

Required:
1. Compute the direct materials price and quantity variances for the month.
Actual Quantity of inputs @ actual price: (AQI x AP) = 20,000 x $0.2 = $4000
Actual Quantity of inputs @ std. price: (AQI x SP) = 20,000 x $0.25 = $5000
Standard Q allowed for output @ std price: (SQIA x SP) = (3000 x 6) x $0.25 = $4500

Price Variance = $1000 F

Quantity Variance = $500 U
Total Flex. Budget DM Variance, $500 F

SHORTCUT:
Materials Price Variance = AQI purchased (AP-SP) = 20,000 (0.2 – 0.25) = -1000 F
Possible Reasons: Purchase discount or lower grade materials.
Materials Quantity Variance = SP (AQI used – SQI allowed) = 0.25 (20,000 – 18,000) =
$500 unfavourable (because used more than allowed)
Inexperienced labour used more materials, lower grade of materials created more
waste.

2. Compute the direct labour rate and efficiency variances for the month.

Labour Rate Variance = AH (AR-SR) = 7500 (12-12) = 0

Efficiency Variance = SR (AH-SH) = $12.00 (625 – 600) = $300 U
Note: 600 comes from 3000 units x 0.2 = 600

Lower grade of materials harder to use, taking more time.

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ACC 1110 Chapter 10 6

J. Pai Standard Costs and Overhead Analysis
PROBLEM 10–22 Basic Variance Analysis [LO2, LO3, LO4]

VitalAid Inc. manufactures a vacuum-sealed high-protein food supplement that it sells to food
aid organizations around the world. The company uses variable costing in conjunction with a
standard costing system and has established the following standards for one package of
VitalAid bars:
Standard Standard Standard
Quantity Price or Rate Cost
Direct materials. . . . . . . . . . . . . . . . . . . . . . . . . . . .350 grams $12.00 per kg $4.20
Direct labour. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .0.25 hours $13.00 per hour $3.25
Variable manufacturing overhead. . . . . . . . . . . 0.5 hours $1.60 per hour $0.80
Total standard variable cost. . . . . . . . . . . . . . . . $8.25

During October, the company recorded the following activity relative to production of
VitalAid:
a. The company produced 4,000 packages during October. (OUTPUT)
b. A total of 1,800 kilograms of material was purchased at a cost of $19,800.
c. There was no beginning inventory of materials; however, at the end of the month, 300
kilograms of material remained in ending inventory. (USED 1500 KG THEN!)
d. The company employs 5 people to work on the production of VitalAid. During October,
each employee worked an average of 185 hours at an average rate of $14.00 per hour.
e. Variable manufacturing overhead is assigned to VitalAid on the basis of direct
labour- hours. Variable manufacturing overhead costs during October totalled
$1,850.
The company’s management is anxious to determine the efficiency of the VitalAid
production activities.

Required:

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1. a. Compute the price and quantity variances for direct materials used in the
production of VitalAid.

b. The materials were purchased from a new supplier who is anxious to enter into a
long-term purchase contract. Would you recommend that the company sign the
contract? Explain.

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J. Pai Standard Costs and Overhead Analysis
2. a. Compute the rate and efficiency variances for labour employed in the production of
VitalAid.

b. In the past, the 5 people employed in the production of VitalAid consisted of 3 senior
workers and 2 assistants. During October, the company experimented with 4 senior
workers and 1 assistant. Would you recommend that the new labour mix be
continued? Explain.]

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J. Pai Standard Costs and Overhead Analysis

3. Compute the variable overhead spending and efficiency variances. What relationship can
you see between this efficiency variance and the labour efficiency variance?

^^^^^^^^ this is important!

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ACC 1110 Chapter 10 7

J. Pai Standard Costs and Overhead Analysis
CASE 10–36 Behavioural Impact of Standard Costs and Variances [LO1] (CMA adapted)
EXAM TYPE QUESTION!!
José Flores is the manufacturing supervisor of Newmarket Manufacturing Company, which
produces a variety of plastic products. Some of these products are standard items that are listed in the
company’s catalogue, while others are made to customer specifications. Each month, Flores receives a
performance report showing the budget for the month, the actual activity, and the variance between
budget and actual. Part of Flores’s annual performance evaluation is based on his department’s
performance against budget. Newmarket’s purchasing manager, Adriana Goster, also receives monthly
performance reports, and she, too, is evaluated in part on the basis of these reports.

The monthly reports for June had just been distributed when Flores met Goster in the
hallway outside their offices. Scowling, Flores began the conversation, “I see we have another set of
monthly performance reports hand-delivered by that not-very-nice junior employee in the
budget office. He seemed pleased to tell me that I’m in trouble with my performance again.”

Goster : I got the same treatment. All I ever hear about are the things I’ve done wrong. Now I’ll
have to spend a lot of time reviewing the report and preparing explanations. The worst part
is that it’s now July 21, so the information is almost a month old and we have to spend all
this time on history.

Flores: My biggest gripe is that our production activity varies a lot from month to month, but
we’re given an annual budget that’s written in stone. Last month we were shut down for three days
when a strike delayed delivery of the basic ingredient used in our plastic formulation, and we had
already exhausted our inventory. You know about that problem, though, because we asked you to
call all over the country to find an alternative source of supply. When we got what we needed on a
rush basis, we had to pay more than we normally do.

Goster : I expect problems like that to pop up from time to time—that’s part of my job—but
now we’ll both have to take a careful look at our reports to see where the charges are
reflected for that rush order. Every month I spend more time making sure that I really
should be charged for each item reported than I do making plans for my department’s daily
work. It’s really frustrating to see charges for things I have no control over.

Flores: The way we get information doesn’t help, either. I don’t get copies of the reports you
get, yet a lot of what I do is affected by your department, and by most of our other
departments. Why do the budget and accounting people assume that I should be told only about my
operations, even though the president regularly gives us pep talks about how we all need to work
together as a team?

Goster : I seem to get more reports than I need, and I am never asked to comment on them
until top management calls me onto the carpet about my department’s shortcomings. Do
you ever hear comments when your department shines?

Flores: I guess they don’t have time to review the good news. One of my problems is that all
the reports are in dollars and cents. I work with people, machines, and materials. I need
information to help me solve this month ’s problems—not another report of the dollars
expended last month or the month before.

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ACC 1110 Chapter 10 8

J. Pai Standard Costs and Overhead Analysis
CASE 10–36 Behavioural Impact of Standard Costs and Variances [Continued]

Required:
1. Based on the conversation between Flores and Goster, describe the likely motivation and
behaviour of these two employees resulting from Newmarket Manufacturing Company’s
standard cost and variance reporting system.

Solution:
Based on the conversation between Jose Flores and Adriana Goster, it seems likely that their
motivation would be stifled by the variance reporting system at Newmarket Manufacturing
Company. Their behaviour may include any of the following:
• Suboptimization, a condition in which individual managers disregard major company
goals and focus their attention solely on their own division’s activities.
• Frustration from untimely reports and formats that are not useful in their daily activities.
• Variance report not timely for corrective actions
• Monthly production variations not reflected/supported in budget report, appeared to have
inadequately compared actual against static budget for evaluation
• Not taking feedback from each department
• Format not catered to departmental needs
• Variances not identified by department
• Missing relevant content / filled with secondary info
• Variance formats hard to communicate to staff (eg. Variance isn’t separated into
price and quantity variances)
• Failing to communicate effectively the overall corporate goals, each department tends to
focus only on its own variances, not thinking of possible links
2. When it is properly implemented, both employees and companies should benefit from
a system involving standard costs and variances.
a. Describe the benefits that can be realized from a standard costing system.
b. Based on the situation presented above, recommend ways for Newmarket
Manufacturing Company to improve its standard cost and variance reporting
system so as to increase employee motivation

Benefits include:
 Provide standards and resources of performance evaluation programs
 Emphasize teamwork and inter-departmental dependence and operation
 Timely reporting provides useful feedback to accountable individuals to identify
problems and aid in solving them
Recommendation:
 Introduce flexible budgeting system that relates actual expenditures to actual levels of
production on a monthly basis
 The budgeting process should be participative rather than imposed to encourage a
tight-yet reasonable standard and budget
 Only those costs that are controllable by managers should be included in variance
analysis
 Distribute reports on a more timely basis to allow quick resolution of problems
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ACC 1110 Chapter 10 8

J. Pai Standard Costs and Overhead Analysis

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